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CF Workshop - by Peyton Young - "How Likely is Contagion in Financial Networks?"

When Feb 19, 2013
from 05:00 PM to 06:00 PM
Where Barbara White Room, Newnham College
Contact Name
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"How Likely is Contagion in Financial Networks?"

 

Peyton Young, University of Oxford

 

Abstract:

Interconnections among financial institutions create potential channels for contagion and amplification
of shocks to the financial system. We propose precise definitions of these concepts and analyze
their magnitude. Contagion occurs when a shock to the assets of a single firm causes other firms
to default through the network of obligations; amplification occurs when losses among defaulting
nodes keep escalating due to their indebtedness to one another. Contagion is weak if the probability
of default through contagion is no greater than the probability of default through independent
direct shocks to the defaulting nodes. We derive a general formula which shows that, for a wide
variety of shock distributions, contagion is weak unless the triggering node is large and/or highly
leveraged compared to the nodes it topples through contagion. We also estimate how much the
interconnections between nodes increase total losses beyond the level that would be incurred without
interconnections. A distinguishing feature of our approach is that the results do not depend on
the specific topology: they hold for any financial network with a given distribution of bank sizes
and leverage levels. We apply the framework to European Banking Authority data and show that
both the probability of contagion and the expected increase in losses are small under a wide variety
of shock distributions. Our conclusion is that the direct transmission of shocks through payment
obligations does not have a major effect on defaults and losses; other mechanisms such as loss of
confidence and declines in credit quality are more likely sources of contagion.

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